Securities and Exchange Commission v. Kovzan

Filing 113

MEMORANDUM AND ORDER - 96 Defendant's Motion for Review of part of the Magistrate Judge's Memorandum and Order of July 31, 2012, is granted; the Court sets aside that portion of the Magistrate Judge's Order, and defendant's mot ion to compel is granted with respect to the documents discussed herein. Plaintiff SEC shall produce the requested documents in accordance with this Order on or before November 9, 2012.. Signed by District Judge John W. Lungstrum on 10/10/2012. (ses)

IN THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF KANSAS

SECURITIES AND EXCHANGE
COMMISSION,

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Plaintiff,
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v.
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STEPHEN M. KOVZAN,
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Defendant.
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_______________________________________)

Case No. 11-2017-JWL

MEMORANDUM AND ORDER
In this case, the Securities and Exchange Commission (“SEC”) has brought
various claims against defendant Stephen M. Kovzan under the federal Securities Act
of 1933 (“Securities Act”), 15 U.S.C. § 77a et seq., and the federal Securities Exchange
Act of 1934 (“Exchange Act”), 15 U.S.C. § 78a et seq. This matter presently comes
before the Court on defendant’s motion for review (Doc. # 96) of part of the Magistrate
Judge’s Memorandum and Order of July 31, 2012, by which the Magistrate Judge denied
defendant’s motion to compel the SEC’s production of certain documents. For the
reasons set forth below, the motion for review is granted; the Court sets aside that
portion of the Magistrate Judge’s Order, and defendant’s motion to compel is granted
with respect to the documents at issue in this motion for review. The SEC must produce

the requested documents on or before November 9, 2012.1

I.

Background

In this civil enforcement action, the SEC seeks civil money penalties, an
injunction against further violations, a prohibition against defendant’s acting as an
officer or director of a publicly-traded company, and disgorgement of any ill-gotten
gains. The SEC’s claims are centered on its allegations that defendant was involved with
the preparation and signing of public SEC filings for his employer, NIC Inc. (“NIC”),
from 2002 to 2006 that were materially false and misleading because they did not
disclose as income certain perquisites received by NIC’s CEO. Among its other claims,
the SEC also alleges that defendant made false or misleading statements to NIC’s
auditors, in violation of Rule 13b2-2 of the Exchange Act, 17 C.F.R. § 240.13b2-2, to
the effect that NIC maintained effective internal controls over financial reporting.
In February 2012, defendant filed a motion to compel certain discovery from the
SEC (Doc. # 61), on which the Magistrate Judge ruled by Memorandum and Order of
July 31, 2012 (Doc. # 89). In that Order, among other rulings, the Magistrate Judge
denied defendant’s motion to compel the production of documents by the SEC pursuant
to defendant’s document requests 11-16, 18-20, 32-34, and 64. Defendant now seeks
review of that portion of the Order.

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The Court denies defendant’s request for oral argument on this motion.
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II.

Standard of Review

Fed. R. Civ. P. 72(a) governs objections to a non-dispositive order by a magistrate
judge. Under that rule, the district court does not conduct a de novo review, but instead
employs a more deferential standard under which the movant must show that the order
“is clearly erroneous or is contrary to law.” See id.; accord First Union Mortgage Corp.
v. Smith, 229 F.3d 992, 995 (10th Cir. 2000); 28 U.S.C. § 636(b)(1)(A). The clearly
erroneous standard “requires that the reviewing court affirm unless it on the entire
evidence is left with the definite and firm conviction that a mistake has been committed.”
See Ocelot Oil Corp. v. Sparrow Indus., 847 F.2d 1458, 1464 (10th Cir. 1988).
“Because a magistrate is afforded broad discretion in the resolution of non-dispositive
discovery disputes, the court will overrule the magistrate’s determination only if this
discretion is abused.” A/R Roofing, L.L.C. v. Certainteed Corp., 2006 WL 3479015, at
*3 (D. Kan. Nov. 30, 2006) (citing Comeau v. Rupp, 762 F. Supp. 1434, 1450 (D. Kan.
1991)); see also 12 Chas. A. Wright, et al., Federal Practice and Procedure: Civil 2d §
3069, at 350 (1997) (discovery disputes might be better characterized as suitable for an
abuse-of-discretion analysis under Rule 72(a)), cited in Microsoft v. MBC Enterprises,
120 F. App’x 234, 243 (10th Cir. 2004).

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III.

Analysis

In its motion to compel, defendant sought responses to document requests 11-16,
18-20, and 32-34, by which defendant sought documents concerning the interpretation
of and SEC interpretative guidance regarding Item 402 of Regulation S-K, 17 C.F.R. §
229.402, which provides detailed instructions for the disclosure of executive
compensation in reports filed with the SEC. Defendant also sought to compel a response
to Request 64, by which defendant sought any documents suggesting that “an internal
control related to the documentation of expenses that had no impact on the ability of a
public company to incorporate those expenses into its financial statements is an ‘internal
control over financial reporting.’”
In response to these requests, the SEC claims that it has produced the following:
“proposed and final rules reflecting amendments to Item 402; more than 800 public
comment letters to the Commission relating to Item 402’s requirements; public
interpretive guidance promulgated by Commission staff relating to Item 402; no-action,
interpretive and exemptive letters, and telephonic interpretations of Commission staff;
a voluminous amount of additional comment letters by Commission staff to public
issuers; and legal interpretations of Item 402 by the Commission in the context of more
than a dozen litigated and administrative proceedings.” (Italics omitted.) The SEC
refused, however, to undertake a search of its staff for other responsive documents,

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including internal SEC documents.2
In his motion for review, defendant states that he is now narrowing his requests
to the following categories of non-privileged documents within the scope of the
document requests: “(1) communications between plaintiff Securities and Exchange
Commission and third parties; (2) non-privileged portions of plaintiff’s internal
documents that reflect communications between plaintiff and third parties; and (3)
plaintiff’s internal documents concerning a final decision as to what guidance, if any, the
SEC staff may provide to reporting companies regarding the meaning of the perquisite
disclosure regulations and the definition of internal control over financial reporting.”
The SEC argues that the present motion for review should be denied because defendant
did not present these specific categories to the Magistrate Judge in briefing the motion
to compel. The Court rejects this argument. By this motion, defendant has not made any
new arguments or sought any discovery outside the scope of the document requests
considered by the Magistrate Judge. Rather, defendant effectively seeks review of the
Magistrate Judge’s ruling only with respect to these categories of responsive documents,
while accepting the Magistrate Judge’s ruling with respect to any other documents within
the scope of the document requests at issue.
A.

Relevance

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The SEC states that such a search would be burdensome, but it did not object on
the basis of burden in litigating the motion to compel. Nor has it elaborated on that
characterization in responding to defendant’s present motion for review. Thus, the Court
does not consider the SEC’s potential burden in producing the requested documents.
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Defendant challenges the Magistrate Judge’s ruling that the requested documents
are not relevant to any claim or defense in the case. In its motion to compel and in this
motion, defendant has argued that the documents are relevant to three specific issues:
scienter; his constitutional defense of fair notice; and the appropriateness of the
injunctive relief requested in this case by the SEC.
As noted above, the Magistrate Judge’s ruling is entitled to some deference from
this Court. Nevertheless, after reviewing this matter, the Court is left with the definite
and firm conviction that the Magistrate Judge mistakenly analyzed this issue of
relevance, and that he therefore clearly erred in denying the motion to compel, at least
with respect to the narrowed categories of documents requested by defendant. See
Ocelot Oil, 847 F.2d at 1464 (defining the clearly erroneous standard). First, with
respect to the issue of scienter, the Magistrate Judge did not consider the objective
component, which could require consideration of the standard of care in the industry, of
the Tenth Circuit’s definition of recklessness for purposes of applying the scienter
requirement in securities fraud cases. He also did not analyze the relevance of the
requested documents to the affirmative defense of fair notice or to the issue of the
injunctive relief requested by the SEC in this case. For these reasons, the Court
concludes that the Magistrate Judge’s ruling regarding relevance is contrary to law. The
Court addresses these three issues in turn.
1.

SCIENTER

Defendant argues that documents concerning the interpretation of Item 402 are
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relevant to the SEC’s claim of defendant’s involvement in the misstatement of an
executive’s compensation based on the alleged reimbursement of expenses incurred by
the executive for personal purposes, including travel between his Wyoming home and
the company’s Kansas headquarters. Defendant’s request 64 relates to the SEC’s claim
that he misrepresented in letters to auditors that the company maintained effective
controls over financial reporting, and defendant argues that the request is relevant to that
claim in light of this Court’s rejection at the pleading stage of defendant’s argument that
such statement could not be false if no financial statements were misstated. See SEC v.
Kovzan, 807 F. Supp. 2d 1024, 1044 (D. Kan. 2011).
Specifically, defendant argues that the requested documents are relevant to
whether he acted with the required scienter. With respect to the SEC’s securities fraud
claims, this Court previously noted that scienter “requires a showing of an intent to
defraud or recklessness.” See id. at 1039 (citing City of Phila. v. Fleming Cos., 264 F.3d
1245, 1257-58 (10th Cir. 2001)). In Fleming, the Tenth Circuit defined recklessness as
“conduct that is an extreme departure from the standards of ordinary care, and which
presents a danger of misleading buyers or sellers that is either known to the defendant
or is so obvious that the actor must have been aware of it.” Fleming, 264 F.3d at 1258
(citing Anixter v. Home-Stake Prod. Co., 77 F.3d 1215, 1232 (10th Cir. 1996)); see also
Dronsejko v. Thornton, 632 F.3d 658, 665 (10th Cir. 2011) (applying this definition of
“recklessness”).

Thus, defendant argues that scienter may include an objective

component, such that the standard of care in the industry is relevant. Defendant similarly
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argues that the SEC’s claim under Rule 13b2-2, relating to the statement about internal
controls, also contains such an objective component, as it is governed at least by a
standard of reasonableness. See, e.g., SEC v. Kelly, 765 F. Supp. 2d 301, 324 (S.D.N.Y
2011).
The Magistrate Judge effectively concluded that scienter relates to what defendant
knew or should have known, and that therefore information may be relevant to scienter
only if known to the public or to defendant. As noted above, however, the Magistrate
Judge clearly erred in failing to consider that evidence of the standard of care in the
industry may be relevant in light of the Tenth Circuit’s definition of “recklessness” or
the reasonableness standard that the SEC seeks to apply to the Rule 13b2-2 claim.
The Court agrees with defendant that, under the Tenth Circuit’s definition of
recklessness to include an extreme departure from the standard of ordinary care,
evidence of the practice within the industry may be relevant to the issue of scienter. Of
course, the SEC could attempt to prove scienter in this case solely by showing an intent
to defraud, thereby removing the issue recklessness from the case. The SEC has not
limited its case in that manner, however. Accordingly, the Court concludes that
defendant is entitled to seek evidence relating to the industry standard, whether or not
such evidence was previously known to him or the public. The Court notes in this regard
that that evidence need not be ultimately admissible to be discoverable, see Fed. R. Civ.
P. 26(b)(1), and the Court concludes that these requests are reasonably calculated to lead
to the discovery of admissible evidence relevant to the issue of scienter.
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The Court does not find the opinion in SEC v. Nacchio, 704 F. Supp. 2d 1099 (D.
Colo. 2010), on which the Magistrate Judge relied, to be persuasive, as that court did not
consider the Tenth Circuit’s definition of the recklessness prong of the scienter
requirement. In Nacchio, the court, after discussing the application of privilege to a
request for deposition answers from the SEC concerning internal SEC communications,
stated at the conclusion of its analysis that the requested information also appeared to be
irrelevant. See id. at 1112. In a footnote, without citation to authority, the court rejected
the defendant’s argument that uncertainty within the SEC was relevant to his own lack
of understanding of the applicable regulations, and the court stated that the SEC’s
knowledge or beliefs were irrelevant to the defendant’s scienter, which turned on his
own thought process. See id. at 1112 n.16. Thus, the court did not take into account the
objective component of recklessness that may make industry standards relevant under
the Tenth Circuit’s definition. Moreover, in the present case, and particularly in his
narrowed requests, defendant does not merely seek the SEC’s internal communications,
but seeks information regarding communications between the SEC and third parties.
Thus, the Court is not persuaded by the Nacchio court’s ruling relating to the particular
discovery before it.
In its brief to this Court, the SEC addressed this issue of the standard of care
within the industry by citing cases in which two courts noted that acts in conformity with
industry practice may still be fraudulent, as that practice itself may be fraudulent. See
Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 274 (3d Cir.
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1998); SEC v. Rauscher Pierce Refsnes, Inc., 17 F. Supp. 2d 985, 1001 (D. Ariz. 1998).
Those cases, however, only stand for the proposition that the industry standard is not
necessarily determinative; they do not support the SEC’s position that evidence of the
industry standard is not relevant. Certainly, the SEC might eventually argue that
evidence of confusion regarding the regulations in communications to the SEC does not
actually represent the state of the industry practice; again, however, the issue of the
admissibility of the evidence is for a later day.
Accordingly, in the absence of binding or persuasive authority that
communications between the SEC and third parties, although not known by the public
or defendant, cannot be relevant to the issue of recklessness, the Court concludes that
defendant’s requests could properly lead to the discovery of admissible evidence on the
issue of scienter. The Court thus overrules the SEC’s relevance objection.
2.

FAIR NOTICE

Defendant also argues that the requested discovery is relevant to his constitutional
fair notice defense, by which defendant asserts that the applicable regulations were
impermissibly vague, particularly in light of the lack of guidance issued by the SEC.
See, e.g., FCC v. Fox Television Stations, Inc., 132 S. Ct. 2307, 2317 (2012). As noted
above, the Magistrate Judge’s ruling does not contain any analysis of the relevance of
the requested discovery to defendant’s fair notice defense. In its brief to this Court, the
SEC has responded to this argument solely by arguing the merits of the fair notice
defense in this case. The Court is not inclined to consider those merits in this context of
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a motion for review of a discovery ruling, however. The SEC has not provided any
reason why the (later) consideration of this defense on the merits may not include
matters contained in non-public documents held by the SEC.
The Court concludes that discovery of such non-public documents may lead to
the discovery of admissible information relevant to defendant’s fair notice defense. See,
e.g., Ohio Cast Prods., Inc. v. Occupational Safety & Health Rev. Comm’n, 246 F.3d
791, 799 (6th Cir. 2001) (industry practice may be considered in ruling on fair notice
defense); General Elec. Co. v. EPA, 53 F.3d 1324, 1332 (D.C. Cir. 1995) (confusion and
inconsistent interpretations within an agency support a fair notice defense). Thus,
defendant’s requests may be relevant to this issue as well.
3.

INJUNCTIVE RELIEF

Finally, defendant argued in its motion to compel, and argues in this motion, that
the requested documents are relevant to the injunctive relief requested by the SEC in this
suit, including an officer-director bar. Specifically, defendant argues that the industry
practice, guidance given to other companies, and confusion within the SEC itself may
be relevant to the degree of defendant’s scienter—how reckless he was—which in turn
is relevant to whether injunctive relief should be granted. See, e.g., SEC v. Pros Int’l,
994 F.2d 767, 769 (10th Cir. 1993) (degree of scienter is relevant to propriety of
injunctive relief for securities violation).
Neither the Magistrate Judge in his order nor the SEC in responding to the present
motion addressed this argument by defendant. The Court agrees with defendant, for the
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reasons argued by him, that the requested documents may be relevant to this issue of the
relief sought by the SEC. Thus, these requests are relevant with respect to multiple
issues, and the Magistrate Judge’s ruling to the contrary therefore constitutes an abuse
of his discretion and is contrary to law.
B.

Other Bases for Denial of the Motion to Compel

The Magistrate Judge separately ruled that the requests relating to Item 402 are
facially overbroad, seemingly on two bases. First, the Magistrate Judge noted that some
of the requests were “sweeping” and applied to communications of persons outside or
within the SEC. The Magistrate Judge did not explain, however, how these requests
were impermissibly broad. That conclusion by the Magistrate Judge was likely
influenced by his ruling, hereby reversed by this Court, that the requests sought
irrelevant information. The Court does not find that these requests are fatally overbroad,
particularly as narrowed by defendant in his present motion. The Magistrate Judge also
noted that, in the copy provided to him, many of the requests contained no temporal
limitations. This issue of temporal limitations, however, was not raised by the SEC in
opposing the motion to compel, and the requests’ instructions (not provided to the
Magistrate Judge) do specifically request documents from 2002 to 2006. Thus, the Court
overrules any objection that these requests are overbroad.
The Magistrate Judge also concluded that defendant’s document requests sought
documents protected by the deliberative process privilege. The requests, however, also
seek documents relating to communications with third parties that would not fall within
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that privilege, and in narrowing his requests, defendant seeks only non-privileged
documents. Thus, the fact that some documents responsive to the original requests may
be privileged does not provide a basis for denying the motion to compel the production
of non-privileged responsive documents. In light of the Court’s ruling that the requested
information is relevant, the Court concludes that the Magistrate Judge therefore clearly
erred to the extent that it denied the motion to compel in its entirety for the separate
reason that the requests sought some documents that would be privileged.
For these reasons, the Court concludes that defendant’s motion to compel, as it
relates to the narrow categories of documents set forth by defendant in the present
motion, should not have been denied. Defendant’s present motion for review is therefore
granted, and the SEC must produce the requested documents on or before November 9,
2012.
C.

Production Required by the SEC

Finally, the SEC argues that, in providing the public documents, it has already
produced the requested third-party communications. The SEC has not shown or stated,
however, that all communications with third parties concerning these regulations were
made public. Indeed, it appears that the SEC has not even conducted a search to confirm
that all such third-party communications have been produced. Moreover, defendant has
requested internal documents that reflect third-party communications, which documents
would not seem to have been included within the SEC’s prior production.
The SEC also asserts that additional responsive documents will naturally fall
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within the deliberative process privilege. Again, however, the SEC has not yet
conducted the relevant search, and thus it cannot credibly make that determination. The
Court agrees that documents “concerning” the SEC’s final decisions might be privileged,
but the Court cannot issue a blanket exemption for such documents. The SEC may
withhold any privileged documents that are responsive to defendant’s narrowed requests
(while adding such documents to its privilege log), but it must nevertheless search for
responsive documents and produce all such documents that are not privileged.3

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The issue of whether any particular documents actually fall within the
deliberative process privilege is not presently before the Court.
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IT IS THEREFORE ORDERED BY THE COURT THAT defendant’s motion
for review (Doc. # 96) of part of the Magistrate Judge’s Memorandum and Order of July
31, 2012, is granted; the Court sets aside that portion of the Magistrate Judge’s Order,
and defendant’s motion to compel is granted with respect to the documents discussed
herein. Plaintiff SEC shall produce the requested documents in accordance with this
Order on or before November 9, 2012.

IT IS SO ORDERED.

Dated this 10th day of October, 2012, in Kansas City, Kansas.

s/ John W. Lungstrum _______
John W. Lungstrum
United States District Judge

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